Addressing the Disconnect in Global Liquidity Conditions

As I noted recently in a small note on the state of play in the global economy one of the current important things to watch out for was the disconnect in global liquidity conditions. Let me refresh your memory just a bit ...

In this way, it seems to me that what we have is a great disconnect in the global liquidity channels. On the one side the subprime turmoil has had, as one of many, the nasty side effect that the interbank market has dried almost entirely up. This might to many seem a technical issue but quite simply the modern financial system needs a certain amount of liquidity to work smoothly and in the present situation the liquidity is just not there.

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(...) what remains is then, as I noted, somewhat of a disconnect since if you look at the current trends in inflation as well as general liquidity conditions in some parts of the global system it could indeed seem as if, as Edward so aptly put it in recently in the context of Russia, that too much money is chasing too few people. At least, with Citigroup recently securing a $7.5 billion cash infusion from Abu Dhabi coming at a rather comfortable time in the wake of yet another publication of hefty losses on the back of the subprime turmoil and as people are now contemplating whether China should buy the US mortgage lender and provider (now, it seems would be a good time to secure a decent price) the global liquidity conditions have a flip side and it has SWF and (in general) export nations written all over it.

Clearly, the former aspect of this disconnect as I have chosen to coin it seems to be getting the lion's share of attention at the moment but of course also the most unwelcome pick up inflation we are seeing across the globe basically seems to be attracting a rather large proportion of attention. The main headache of all looks to have shored up at the front doors of just about every central bank in the modern developed world as they now face the mother of all trade-offs and I would not be surprised if the next weeks and months will make for a come back of an old foe under the name of stagflation. As such, and after having been riding through the last decade on the wings of the great disinflation and those deflationary imports from the BRICs it now seems as if those very same behemoths of emerging economies have shifted from being deflationary to inflationary. At least, this is the talk of the day at the moment since the current surge in inflation seems to be driven by base commodities such as food and energy which suggests that, in these specific large commodity categories at least, the great disinflation is over. Of course, inflation other places in the world is driven by a fundamental dis-equilibrium between capacity for growth and liquidity/expectations of catch-up and growth convergence; hint ... Russia and Eastern Europe would be the main candidates here. In any case, and to the great discomfort of some central banks still seem, and duly so in my opinion, most concerned with trying to apply some moisture to the interbank market which has gone from a smoothly running river to a barren wasteland over the course of just a few months in 2007. This led, this Wednesday, to a joint move by central banks instigated to try once and for all to make those liquidity channels work again ...

The central banks have pinched each others’ best ideas for how best to ensure that liquidity gets where it is needed. And they have also, in effect, acknowledged the international nature of the liquidity squeeze, by promising to provide reciprocal currency-swap lines. (...) The hope is that by extending the maturity of central-bank money, broadening the range of collateral against which banks can borrow and shifting from direct lending to an auction, the central bankers will bring down spreads in the one- and three-month money markets. There will be no net addition of liquidity. What the central bankers add at longer-term maturities, they will take out in the overnight market.

So, all is good then? Well not quite since the main question remains of whether in fact this will work. Roubini certainly does not think so and advocates that aggressive cuts in the short term nominal interest rates are necessary in stead. Eurointelligence does not seem to be too happy about it either although I suspect that they don't agree with Rouibini as to the provisions of the rememdy. Whether this will have a serious effect in the money markets is yet to be seen but here is to hoping. One thing is for sure. The economic barometer is heading for sub-zero not least in the Eurozone and the longer we continue to fight off windmills for trolls the more painful this will be even if those mills look might dangerous indeed.